Fully Accountable

The largest gripe that I’ve had with Wall Street Analysts is that they lack accountability. They flip-flop around their investment thesis and fundamental analysis of a situation. In my regard, the individual investor has many reasons to completely tune out all the noise that they hear and draw their own conclusions from macro-economic events and their own due diligence of a companies released earnings.

Over the past 400+ articles, I’ve mostly posted my buys and sells, with exact prices. This is to establish accountability and to form a track record. I’ve always said, regardless of how a person finds their stock picks, all that matters is performance in B&W. It doesn’t matter if you employ throwing darts or advanced quant analysis. The best written article and in-depth analysis is worthless if it consistently loses you money in investing.

My approach has always been basic and straightforward. Buy cash rich companies with low debt or entire sectors that have been shorted due to unfavorable market conditions. I know that my own track record is far from perfect, however I have the same conviction and passion for each investment I make even if the last was losing.

In the market, a loss is never a loss until you sell. If you are confident you bought a stock at good value you will be able to sleep well at night and won’t be afraid to buy more at low prices. You never buy more just because the price drops, you buy more because the company continues to be a good value. If the company stops being a good value, you cut your losses and sell, regardless if the price is high or low.

I do see a crash coming and with the same accountability I am going to post my targets as I always have.

My price target for gold is $1,100 by the first quarter of 2009. My top picks continue to be Yamana Gold (AUY) and Barrick Gold (ABX).

My target for silver is $25 by the first quarter of 2009. My top picks continue to be Pan American Silver (PAAS), Silver Wheaton (SLW) and Hecla Mining (HL).

My favorite base metals stock is Lundin Mining (LMC). I’ve written in detail about the stock in the past, so use the search function on my blog. Today the stock is trading in the mid $6 range. I fully expect LMC to break $10, a 50% gain, in the next 6-12 months.

I would like to remind readers that the first time I bought Yamana, Pan American Silver and Silver Wheaton some continued to drop from my purchase price almost 30%. In retrospect, I saw the value in strong earnings and smelled a good value brewing. All of the stocks above returned 40% or greater for me in a matter of months. I see the same opportunity today in precious metals stocks. It will not be a smooth ride given the volatility in precious metals. Unusual volatility means strong swings in both directions. The farther it falls the faster it will rise as a sector. There are plenty of precious metal stocks, especially juniors and mid-tier producers that are trading as if gold were in the $600-$700 range and silver were in the $12-$14 range. In light of the strong earnings almost the entire sector is undervalued and soon Wall Street will come to realize and report about it. There is real possibility of war between Israel and Iran. There is a real possibility of economic disaster. There is strong threat of inflation. All of these are positive for precious metals.

I am going to start entering positions in July and hopefully 2008 will be another top notch year for myself and fellow Raw Greed readers. Gradual accumulation and diversification is key. A year from now those who have the conviction to buy will be happily rewarded.

Finally, I will share a thought left to me by the former CIO of General Motors Asset Management. He asked me, “is an entrepreneur risky?”. His answer was solidly no. An entrepreneur fully believes in what they are doing or they wouldn’t do it at all, so they are not risk takers. A conservative entrepreneur and those who are fully accountable should be followed carefully. Individual investors are very much mini-entrepreneurs putting their money to good use.

Disclaimer: The author currently holds a long position in Lundin Mining.

A Possible Economic Crash

There are a number of startling factors for investors to consider when evaluating the possibility of a larger looming economic crises. A few authors have guessed that the majority of writedowns are now done and that the worst may be past us. From the most recent news, I believe we may extend losses past the most recent credit crises fueled by collateralized debt. We may soon face a banking crises larger than the Savings and Loan crises of the late 1980’s.

Here are a few factors to consider:

1) The Fed may increase interest rates in the near future. An increase in rates is bullish for the dollar and necessary to fight inflation. An increase would add tremendous pressure to an already fragile housing market by making payments on adjustable rate mortgages more expensive. Increases would also make borrowing more expensive and would restrict access to already tight credit. The potential impact of rate increases is unknown.

2) Any failure in the derivatives market would signal the beginning of an imminent crash. Estimates vary wildly over the total value of the derivatives market. The Financial Times recently estimated that the size of the derivatives markets stood at roughly $450 trillion dollars. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

Taken from Investopedia:

[A]…derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Due to the complex structure of derivatives it becomes very difficult to evaluate the underlying assets of many derivatives. Problems in the industry could lead to massive derivative writedowns by banks. Derivatives could form an extension of the collateralized debt obligation (CDO) and mortagage backed security (MBS) problems that fueled most of the recent writedowns by financial institutions. If there are too many sellers and not enough buyers in the derivatives market, investments become stagnant and pose the possibility of devaluation if anxious sellers seek to cash out.

My guess is that the derivatives estimate from The Bank for International Settlements is the most accurate. Taken from The Bank of International Settlements website: The Bank for International Settlements (BIS) is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks. The bank was established on May 17th, 1930 and is headquartered in Switzerland. BIS is the world’s oldest international financial organization and currently includes 55 member central banks.

3) Leverage is out of control. As we learned from the Bear Stearns Crash, leverage can turn against you very quickly. Bear Stearns leveraged 11.8 billion to control a balance sheet of 395 billion. Carlyle Capital leveraged its balance sheet 32 times to own $21.7 billion in mortgage backed securities, primarily AAA-rated bonds guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE). Carlye Capital’s portfolio was backed by just $670 million in equity. The problem of leverage is prominent by all major big balance sheet banks such as Goldman Sachs (GS) and JPMorgan Chase (JPM) is very real as they provide access to credit and frequently loan money between each other. Any devaluation of assets or calls for more collateral on loans could lead to forced margin calls and major additional writedowns for banks.

4) Credit ratings on bond insurers Ambac (ABK) and MBIA (MBIA) fall. Ockham Research wrote on February 28th, 2008:

“Citigroup (C), Wachovia (WB), and UBS (UBS) among others need to keep Ambac healthy as the ripple effect from an Ambac bankruptcy would be massive. Oppenheimer estimates that the major banks have $70 billion of exposure to Ambac and the bonds they insure.

Clearly, Ambac losing its credit rating of AAA or declaring bankruptcy would be catastrophic. If the worst were to occur it would make the housing crisis pale in comparison. The banks act as underwriters for billions of dollars in corporate bonds of which Ambac and MBIA are the two main insurers.”

Banks like UBS (UBS), Citigroup (C) and Merrill Lynch (MER) buy bond insurance as a hedge from Ambac and MBIA. If the insurer were to go out of business, 100% of the default risk is exposed to the bank. Banks have taken insurance on trillions of dollars of collateralized debt obligations and other mortgage backed securities. The potential impact of bond insurers going out of business for banks is tremendous. Market Watch is reporting that Ambac’s drop from AAA to AA is going to cost UBS, Citigroup and Merrill Lynch an estimated additional $10 Billion in new writedowns. This is money that the banks can’t afford to continue losing.

5) The Fed is printing money at an ever quicker pace. I’ve covered most of this in my previous article on How to Predict the Price of Goods. An increase in the money supply helps to alleviate access to credit and offers additional available cash to banks in the form of Fed loans. Increases also lead to an inflationary economy and possible drop in the dollar.

6) Inflation is out of control. Basic necessities like food and energy prices have skyrocketed 300% or more in recent years.

7) Eli Hoffman reported that financial performance of mutual funds in 2008 may be worse than the year of the .com crash. Eli writes that “As of January, 2007, nearly 1,400 mutual funds were earning 15% or more. This January, just 270 funds hit that number — an 80% decline. From December 2000 to December 2001 — the bursting of the tech bubble — the 12-month drop was only 57%.”

There are many situations that may play out. The extreme economic collapse would be a failure of the banking system that would mean massive bank runs and a large devaluation of the dollar. Since the risk of an economic crash is very real, and may be the worst since the great depression, I am continuing to recommend cycling into physical assets and a diversified portfolio of non-cash assets.

Food for thought: Stocks and bonds are held in a clearing account by your bank or brokerage. If a bank run causes you to lose your money, eventually your stocks and bonds will be returned to you since technically they can be delivered in the form of stock certificates and paper contracts. Picking the correct recession resistant investments will be key to preserving capital in the event of an economic crash.

The good news is that if we are able to quickly emerge from a recession, every post economic recovery has lead to higher wages and asset appreciation. This has been true all the way from the Great Depression to the .com lead recession.

*Disclaimer: The author does not own a position in any of the stocks above.

Hyperinflation Here We Come

I started writing on the subject of hyperinflation almost 4 years ago. One definition of hyperinflation, offered by Wikipedia, is “a cumulative inflation rate over three years approaching 100%”. Investopedia defines hyperinflation as “Extremely rapid or out of control inflation.” Anyone who was expecting a recession in the U.S. should also be prepared to look at the process of recovery. A trend has been set since the Al Greenspan era to flood the U.S. economy with newly printed dollars and access to cheap money through low interest rates. It seems that Ben Bernanke is following the same trend of increasing the money supply and keeping interest rates low till we emerge from recent economic problems.

The beginning of hyperinflation is evident from the chart below. Of the 30 cars below, it now costs $114 to fill up a Toyota Sequoia SUV in California. The Toyota stands firmly in the middle of the list, with 21 out of the 30 models costing more than $100 to fill up.

I firmly believe that we are looking at the value of money dropping 10 times in the next decade. I believe $100 will be worth roughly $10. There is simply too much new money being printed by the Fed competing for the same goods. If we look at our emergence from the 2001 recession, we already saw the cost of property, luxury goods, travel and in some cases food increase 300-400%. Now that we are entering a new recession, when we recover the price of goods should again dramatically increase. Holding cash at the moment is the worst possible thing a person could do. I suggest buying anything, from stocks to property that you believe is a reasonable quality investment. When we emerge from a recession, stocks, property, and a variety of other investments will adjust themselves to reflect the true value of future dollars.

There will come a time when a $1,000,000 a year salary will be as common as a $100,000 a year salary today. The problem is no one sees it coming. It typically happens in a short time-frame and catches investors off guard. Many of us ignored the opportunity to buy property or stocks in 2001 when prices were low. Many of us will now miss the chance to buy property or stocks in 2008-2009.

Raw Greed’s investing has been focused on identifying trends in advance and setting up strategies to take advantage of oversold conditions. Five years ago, I was buying in and out of technology and airline stocks. For the past three years, I have been buying in and out of precious metals stocks. I believe that we are approaching a mania phase for energy and precious metals. In the next year or two I am guessing that I will exit precious metal stocks and start to invest in financial and home building stocks.

At the moment there are an incredible amount of deals in the market with some sectors off a staggering 70% or greater. Good and bad stocks, bonds and property have been lumped together and sold off. I don’t believe we have hit a bottom yet, but I do believe we are approaching one. Since no one knows when the exact bottom is, I believe investors should begin to build their positions while the economy is slumping. The old saying “the baby will be thrown out with the bath water” is going to apply very soon. Investors will may have a chance to buy GE, General Electric Company or HD, The Home Depot, Inc. at a P/E under 10. Insurers like AIG, American International Group, Inc. and financials like LEH, Lehman Brothers Holdings Inc. and C, Citigroup, Inc. are all down in the 60-70% range compared to year ago highs. If these stocks were to slide another 20-30%, we would firmly be 80-90% off from year ago highs indicating a permabear mentality.

It seems that whenever a person decides to buy a stock in a slumping market, the stock will keep falling, causing some degree of fear and angst. Investors should take comfort in knowing they paid .10-.20 on the dollar for a stock that will likely survive and thrive when the economy recovers. There may be another Bear Sterns collapse in the meantime, so diversification is key. Lets say you took a dollar and broke it into 10 varied investments that were down 80-90%. If one were to go out of business you would be left with 9 investments that will likely return multiple times your cost as we emerge from a recession. If you are buying .10-.20 on the dollar, only one out of your ten investments has to recover halfway from year ago prices to bring you to a breakeven point to prevent loss from one going out of business. The chances are solidly in favor of the investor who can look past the bearish mentality.

I have no idea if companies like AIG or Lehman Brothers will ever drop to the point where I can buy them .10 on the dollar compared to year ago prices. At the moment, I am going to consider beginning to build a position in these stocks as we are down 60-70%. This range is my initial buy-in with aggressive buying at .10 on the dollar.

At the moment there are people forced to pay $168 to fill up a Chevy Suburban 2500 in California. I’m not sure how much longer can this last until all the new money the Fed is printing goes towards increasing salaries. The recent economic relief checks have been completely absorbed by a months driving for some households. Once we recover and people are able to afford paying $100+ to fill up it will be too late for investors to capitalize on the missed chances. The lost money just by sitting on the sidelines will be very real.

*Disclaimer: The author does not own a position in any of the stocks above.

Falling Global Stock Prices

Some of my readers have asked me if I would be afraid that the market would continue falling 50% or greater. I’m sure to their surprise my response has been “I hope so”.

It is human psychology that leads us to believe that buying in a market where prices are up 300% is safer than buying when the market is down 80%. When markets are dramatically up there is a sense of confidence in the air, when the markets are severely down the confidence is replaced with fear.

If we look at the past decade, many investors missed the chances to buy stocks following the .com crash, 9/11, Tsunami, SARS and now the credit crises. Many investors I knew felt more comfortable buying Pets.com stock at its height instead of buying Amazon (AMZN) when the Nasdaq crashed 80%.

In addition to my typical look at high cash, low debt, high ROE and high ROI, a few simple rules should be stuck to when buying during a market crash.

1) Stick to big names and blue chips stocks.
2) Find companies that have built irreplaceable business models, distribution, infrastructure, support networks and brand names.
3) Buy low and don’t be afraid to buy lower.

By far the credit crises is the most globally wide spread of the problems we have faced since the Nasdaq crash. If the markets continue to fall there will be a chance to start building positions in American Express (AXP) that has built an irreplaceable transaction network, or FedEx (FDX) and UPS (UPS), that have built irreplaceable shipping networks.

Negative pessimism will always pass and when it does the stock market will rally back to previous highs and onward to new highs. If you invest in a basket of stocks, there is always the chance that a few will go out of business. You should keep in mind though that as long as your remaining stock investments recover to previously set highs you will recover your losses. The discount to previously set highs is your hedge.

Lets say you buy 10 blue chip stocks at a 50% discount. If 5 go out of business and 5 recover to original levels you break even. If you buy at a 60%, 70%, 80% or greater discount your hedge grows. At 80% off previous high’s, if you bought 10 stocks, 8 can go out of business and if 2 recover you will break even. The odds are squarely in your favor.

As readers have followed along with Raw Greed, investors know that I often recommend stocks when they have fallen 60% or greater and I’m not afraid to recommend buying more to lower your cost basis. Alternatively, if you’re not sure what to invest in during a market crash, buy an index fund.

Remember that a solid company makes a solid investment long-term. The fun of investing is buying at a discount to what you consider fair value. When broad markets sell off its easier to find those opportunities than when broad markets are setting new high’s.

*Disclaimer: The author does not own a position in any of the stocks above.

Investing in China’s Falling Stock Market

In a follow-up to my article, A True China Bear, I recommend investors to set their sights on China since there may be tremendous upside in the emerging economy. The Shanghai Composite Index (000001.SS) has fallen to 2868 from a high of 6124, a drop of over 50%. The drop below 2900 marks a new 52-week low.

Long-term i’ve written that China may follow and overtake the performance of the Hang Seng Index (^HSI).

Amazingly in 1973 the HSI was valued at a low of 153. Since 1990 the HSI has returned over 15x times its previous value. As we can see with the HSI chart, these opportunities to invest when the market falls don’t come very frequently. As history has shown the market has always rallied to new highs.

Investors can consider purchasing the Morgan Stanley China A Share Fund, Inc. (CAF) or the iShares FTSE/Xinhua China 25 Index ETF (FXI). CAF and FXI trade closely with the performance of the Shanghai Composite Index.

*Disclaimer: The author does not own a position in any of the stocks above.

A Great Gold and Silver Hedge

I’ve written previously about using financial stocks as a hedge against the falling price of gold and silver equities. Gold and silver stocks are currently rising over an unstable global financial climate, rising inflation and a falling dollar. As the financial environment attempts to stabilize, we have seen the recovery of many bank stocks and the fall of most precious metal stocks.

While financial stocks are a great way to hedge a portfolio of gold and silver stocks, I believe I have found another sector that can be used as a more efficient hedge. When we look at creating hedges, I believe looking at volatility is very important. When your hedge moves up 8%, you want your gold and silver positions to move down by a similar amount and vice versa.

One of the primary factors behind the runaway inflation we are experiencing is the rise in oil prices. The inflationary effect of rising oil is positive for gold and silver investors, but negative for sectors like airlines where on average 1/3 of the cost of operating an airline is tied to the price of jet fuel. Oil has been on a tear recently, with some analysts expecting the price of oil reach $200 by the end of the year. As speculation grows over the price of oil, airline stocks have come under pressure and have approached heavily oversold territory.

The airline sector is very cyclical and prone to high volatility. Airlines have been so oversold, that any good news that comes out can cause the entire sector to rally. In the event that oil continues to rise we should see major positive performance from gold and silver stocks. This may be especially true going into the fall which is the traditional season high for physical gold and silver prices. I’ve posted in the past about the historical 10:1 oil to gold ratio and here is the chart again.

I believe oil may trade in the $150-$160 range by the end of 2008. This isn’t a far stretch since oil is now at $139 and another 10 percent move would put the price of oil in the $150-$160 range. The Fed would have to again boost the number of dollars in the economy in order to help people absorb the inflationary effect of rising oil prices. With everything in favor of a falling dollar and an inflationary environment, I would be surprised not to see gold over $1000 again and silver over $20. My own price target for gold is $1100 and silver at $19 by the end of 2008.

If the opposite trend were to occur and oil prices were to drop, easing inflation, I would expect airline stocks to experience a major rally due to the oversold conditions in the entire sector.

Looking at the performance of AMR, AMR Corporation, better known as American Airlines, Inc., and CAL, Continental Airlines Inc. accurately paints the picture.

American Airlines has dropped from a one year high of $29.32 to the current price of $7.13, a drop of 75.68%. Continental Airlines has dropped from a one year high of $38.79 to the current price of $13.87, a drop of 64.24%. In the short-term as you build a hedge using either financial stocks or airlines, there is likely additional room to drop. In the long-term the likelihood of a rally and making money from buying into today’s prices is higher than the probability of sustained lower prices. Looking at the historical charts for C, Citigroup Inc., UBS, UBS AG, AMR and CAL confirms this. The resulting rally out of all the recessions the U.S. has faced has resulted in higher prices.

Having patience is key to buying into a falling market. No one knows when we will reach a bottom, but picking and sticking with your entry prices is key to earning a long-term gain. Very few people can become wealthy overnight, so I always stress buying quality companies at a price you believe is fair. For me I have a chance to begin building a hedge using airlines at a 70% or greater discount on average for an entire sector.

I always keep a practical piece of advice from my parents in mind, “nothing goes up forever”. Having a hedge doesn’t mean you won’t make money, quite the contrary. Either your hedge or main portfolio investment will produce gains. In the stock market nothing is a true loss until you sell. This is why picking quality companies with long-term sustainability is key to seeing an entire sector go through a fall and rise. No one can be right all the time, it’s more a game of who’s turn is it to be right. No matter what angle you look at it from, certain sectors are down 70% or more. The same oversold conditions that formed in 1999-2001 are forming again in different sectors in 2007-2009.

In today’s market I am reminded of a quote from kitco’s Doug Casey for successful investing, “be bold when everyone else is timid and timid when everyone else is bold”.

*Disclaimer: The author does not own a position in any of the stocks mentioned above.